Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

In conversation with Western experts as part of the Valdai Discussion Club in Sochi on September 11, Putin remarked that any effort to push Ukraine toward NATO membership would result in severe countermeasures.59 Meanwhile, $25 billion in foreign capital fled Russia. But that was no cause for panic. This was not 1998. Moscow had ample reserves to deal with such a minor market mood swing. It was America, not Russia, whose financial system looked to be imploding.

by the fall of 2008 the giant wave of capital that had carried Western political influence deep into Eastern Europe was receding fast. A generation of globalization under the sign of Western power and money had reached its limit. For the immediate future, the sheer shock of the financial crisis would tend to dampen geopolitical tensions. But the damage done by the escalation of 2007–2008 would prove to be long lasting.

America’s real estate prices peaked in the summer of 2006 and began, slowly at first, to ease.

As house prices fell, equity dwindled, and the hardest hit slid into negative equity.

sort of contingency that financial engineering was supposed to deal with. Through securitization, risks were supposed to have been spread so that even severe losses would be absorbed across the broad base of the economy. That was the theory.

Though mortgage-backed securities had indeed been sold far and wide, lethal pockets of risk were concentrated in some of the most vulnerable nodes of the shadow banking system. The first mortgage issuers to die were in the bottom tier.

Without valuation the assets could not be used as collateral. Without collateral there was no funding. And if there was no funding all the banks were in trouble, no matter how large their exposure to real estate.

when on September 14, Northern Rock, one of Britain’s largest mortgage lenders, failed.

Northern Rock was a product of Britain’s overheated housing bubble. Formed in the 1960s through amalgamation of two nineteenth-century building societies (thrifts) and headquartered in gritty Newcastle, it had by the 1990s acquired fifty-three competitors across the north of England. To create the platform for further growth in October 1997, it converted from thrift status to a public limited company and floated on the London Stock Exchange. Then, between 1998 and 2007, in a gigantic surge of growth, it quintupled its balance sheet. As house prices faltered, some of its more marginal loans were primed to go bad. It was no surprise that “the Rock” got into trouble. But the obviousness of this connection is deceptive. What triggered the collapse in 2007 were not the loans on its balance sheet but

the mechanism of their funding. Northern Rock was the model of a modern highly leveraged bank: 80 percent of its funding was sourced not from deposits but wholesale, at the lowest rates global money markets would offer. The bank’s 2006 annual report gives an idea of this far-flung funding operation:

“During the year, we raised £3.2 billion medium term wholesale funds from a variety of globally spread sources, with specific emphasis on the US, Europe, Asia and Australia. This included two transactions sold to domestic US investors totalling US$3.5 billion. In January 2007, we raised a further US$2.0 billion under our US MTN [medium-term notes] programme. Key developments during 2006 included the establishment of an Australian debt programme, raising A$1.2 billion from our inaugural issue. This transaction was the largest debut deal in that market for a single A rated financial institution targeted at both domestic Australian investors and the Far East.”

Northern Rock had minimal exposure to US subprime. But that didn’t matter, because it sourced its funding from markets heavily used by banks that did. The bad news from Paribas on August 9 was enough to shut down the interbank lending markets and the market for asset-backed commercial paper. It was the seizure in the funding market that poleaxed the entire securitization business and in particular the European side, which had been most actively involved in the issuance of ABCP. Given Northern Rock’s extreme dependence on wholesale funding, it took only two working days after the markets dried up for the bank to notify the Financial Services Authority of an impending crisis.12 But the Bank of England was in no mood to help. Governor Mervyn King took the view that the overextended mortgage lender should suffer the consequences of its irresponsible expansion. By the end of August Northern Rock’s liquidity problems had become life threatening. But it wasn’t until September 13, after the BBC reported the story and the government acted to address the crisis by announcing a guarantee, that the retail depositors panicked. After that, the main damage to Northern Rock’s balance sheet was done by online withdrawals. The elderly savers queuing in the streets made for alarming TV footage. But it was not their panic that was bringing down the bank. It was a bank run operating on an altogether different scale at the speed of computer terminals in money markets across the world. It was a ...

ABCP was always the weakest link in the shadow banking chain. Repo, as fully collateralized lending, was supposed to be safe. Initially, that expectation was borne out. Bear Stearns, the smallest of the US investment banks, reported the first loss in the firm’s history in the first quarter of 2007.13 As was common knowledge, it was heavily involved in mortgage securitization. That was enough to restrict its access to commercial paper markets. The bank’s ABCP issuance plunged from $21 billion at the end of 2006 to $4 billion a year later. Initially, Bear was able to make up for this shortfall by increasing its repo funding from $69 billion to $102 billion. To back this up, as late as Monday, March 10, 2008, Bear still held an $18

billion “pool” of ultraliquid, high-quality securities. But then collateralized borrowing began to fail too.

Unlike the implosion of ABCP, the “run on repo” was a surprise.14 Under British and American law, the holder of repo collateral is entitled to seize it ahead of any other claimant in the bankruptcy queue. So even allowing for Bear’s large portfolio of toxic mortgage-backed securities, its repo ought to have been good. A Treasury security is a Treasury security. Unfortunately for Bear, given that there were plenty of other counterparties to engage in repo trades with, no one wanted to take the risk of having to seize collateral from a failing bank, even if the collateral was as highly rated and as liquid as US Treasurys. When news of a new round of mortgage failures hit the markets in March 2008 and hedge funds began emptying their prime brokerage accounts, quite suddenly the haircuts Bear Stearns faced in the bilateral repo market steepened and access to trilateral repo funding was shut off. A bank that in early March had easily been able to raise $100 billion overnight in exchange for good collateral could no longer fund itself. On Thursday, March 13, with its liquidity reserve down to only $2 billion, Bear’s directors were told that $14 billi...

Then something even worse began to happen. The uncertainty spread from individual weak banks to the entire system. First in the spring of 2008 and then in June, the haircuts on bilateral repo took a severe step up across the board, for all asset classes, for all parties.15 This meant that the amount of capital that was required to hold the outstanding stock of bonds leaped upward, across the entire banking system. Repo in US Treasurys and GSE-backed mortgage-backed securities was the least badly affected. As top-quality collateral they were reserved mainly for use in triparty repo overseen by JPMorgan Chase and Bank of New York Mello...

market where private label ABS was used as collateral, funding terms were gett...

The step up in haircuts would put huge pressure on the investment banks that relied most heavily on short-term funding markets. And it was clear which of those, after Bear, was most vulnerable. The warning signs at Lehman were unmistakable.17 Like Bear, it was known to have taken huge risks on real estate in the hope of catapulting up the Wall Street league table. It had fully integrated its business with the mortgage securitization pipeline. Since the beginning of 2008, the bank’s stock had lost 73 percent of its value. As at Bear, commercial paper issuance by Lehman fell from $8 billion in 2007 to $4 billion in 2008. Nevertheless, on May 31, 2008, its liquidity pool, which was intended to cover cash outflows over a twelve-month period, was as high as $45 billion.18 In June 2008 investors were sufficiently confident to commit $6 billion in new share capital. What pushed Lehman over the edge were collateral calls by anxious lenders.

Given the falling value of its stock, J.P. Morgan demanded large postings of collateral to back up daytime triparty repo risks. By Tuesday, September 9, allowing for liens on its assets, Lehman’s liquidity pool was down to $22 billion. Two days later, on Thursday, September 11, Lehman was still posting $150 billion as collateral in the repo market.19 But then confidence broke. S&P, Fitch and Moody’s all downgraded Lehman. Its share price fell and with that went its standing in the repo markets; $20 billion in repo did not roll and J.P. Morgan demanded $5 billion in collateral to sustain even the most essential part of Lehman’s triparty repo business. Within a matter of hours on Friday, September 12, the Lehman liquidity pool was down to $1.4 billion and it was clear that, barring a weekend rescue, it would be forced to file for bankruptcy.

Bear and Lehman were badly run. Under intense competitive pressure they made high-risk bets on some of the worst parts of the mortgage securitization business. But they were not exceptional. Merrill Lynch too had huge real estate exposure, and it was funding $194 billion of its balance sheet on a short-term basis in the summer of 2008.20 In total, prior to the Lehman bankruptcy, $2.5 trillion in collateral was posted in the triparty segment of the repo market alone on a daily basis. This gigantic pile of claims and counterclaims could become destabilized in a matter of hours. Market analysts recognized the bimodal quality of this experience. It was a “massive game theory,” one commented.21 In trilateral repo, given the unimpeachable quality of the collateral used, there was effectively no price adjustment mechanism. One day the investment banks, dealers and those they borrowed from and lent securities to all functioned as a gigantic trillion-dollar machine based on confidence and widely acceptable collateral. The next day even a very large player in the system could be shut out.

After Lehman, the next link in the shadow banking chain to come under acute pressure was AIG, the insurer.

But beyond such immediate rescue measures, did the all-out focus on the financial system really serve the interests of the real economy?86 Was the inability to borrow causing a failure of investment and thus the ongoing depression? Or were the collapsed housing market and cash-strapped households curtailing economic activity such that there was no incentive to invest and thus no demand for loans?

Strike with massive force and plan a clear route out.4 It was an analogy that had first been invoked by Larry Summers at the time of the Mexico financial crisis in 1994. Now it became Geithner’s mantra. For him, the “Powell Doctrine applied to international finance” meant “the overwhelming use of force, with a clear strategy for resolution.” As Geithner insisted, “There is more risk and greater cost in gradualism than in aggressive action.” For Geithner and his cohorts it was clear that swift and decisive action paid dividends. Compared with the disastrous performance of the European economy, the United States was set back on track.

Gone were the days when economic policy was about shrinking the state to set free the spontaneous order of market liberty. No longer did wisdom lie in devising predictable rules to curtail the arbitrary discretion of policy makers.

The crisis fighting of 2008–2009 scrambled American politics. The Bush administration lost the backing of much of the congressional Republican Party. The crisis snapped the fragile bond between the GOP’s managerial, big-business elite and its right-wing mass base. As the popular wing of the party, backed by maverick oligarch donors, moved increasingly toward indignant antiestablishment opposition, mainline conservatives like Bernanke and Paulson were left to complain that it was not they who left the party, but the party that left them.8 The Bush administration’s crisis-fighting effort was carried by the Democratic Party’s majorities in Congress. That contradiction would be resolved by Barack Obama’s election victory on November 4, 2008, only weeks after the crisis reached its peak. But the fracture of the American Right would in due course have profound consequences both for America and for the wider world.

In 2007 the best hope of the authorities was still that the private sector might rescue itself.

The scale of that error became clear within hours as the shock wave from the Lehman failure impacted the American and the world economy.

Meanwhile, Morgan Stanley and Goldman, the two investment banks left standing, were under immense funding pressure. One week after Lehman, they were rescued by the transparent expedient of redesignating them as commercial bank holding companies so that they might benefit from the protection of FDIC deposit insurance. But that only increased the burden on the FDIC, which had problems of its own. On September 25 the FDIC closed, broke up and sold off Washington Mutual. With $244 billion in mortgages on the balance sheet, WaMu was the largest commercial bank in American history to fail. J.P. Morgan promptly snapped up WaMu’s network of 2,239 retail branches and their deposits.42 Nor was J.P. Morgan the only buyer that could see the prizes on offer in the giant fire sale. The Japanese bank Mitsubishi was poised to rescue Morgan Stanley by taking a 20 percent stake. Warren Buffett was about to prop up Goldman Sachs with a $5 billion capital injection. But both deals were contingent on the promise of a government backstop.

Treasury was now asking to spend the equivalent of the entire US defense budget on bad mortgage securities.

As one disillusioned British official remarked, the Europeans “didn’t see it coming. They didn’t understand the economics. They didn’t understand how collective action could work.”

Why were the Germans so resistant? After all, Germany had its fair share of ailing banks that might have benefited from a common fund. But the hard truth was that German taxpayers did not want to pay for other people’s bailouts, inside Germany or out. In a broader sense, the question of national versus federal solutions was for Merkel not just a matter of euros and cents. Since 2005 she had been toiling amid the wreckage of Europe’s failed effort to give itself a constitution.

What the 2008 crisis exposed was a dangerous imbalance in the business model of the European banks.

The IMF financed trade deficits and handled public debt crises. It was not in the business of filling gigantic private sector funding gaps. Its programs were denominated in tens of billions of dollars. It was not conceived for an age of trillion-dollar transnational banking.

In the spring of 2008 the decision by Ukrainian president Viktor Yushchenko to apply for NATO membership—eagerly applauded by the Bush administration, Poland and the other East Europeans—split Ukrainian politics. Whereas President Yushchenko threw in his lot with the West, Prime Minister Yulia Tymoshenko favored the policy of balance between Russia and the West that Kiev had pursued since independence and that had made her personal fortune as a kingpin in the gas trade. The war in Georgia in August 2008 divided what was left of the political legacy of the revolution of 2004.57 Then, before the cease-fire in the Caucasus had more than a few weeks to settle, Kiev was rocked by the financial crisis.

Since the 2004 revolution, Ukraine’s economic growth had come to rely on foreign borrowing. By early 2008, foreign funds made up 45 percent

of all corporate financing and 65 percent of household loans in Ukraine.58 Altogether, European banks had lent Ukraine at least $40 billion, with Austrian and French banks responsible for almost half. The onset of the crisis stopped the credit flow. And it hit Ukraine’s exports hard. As one of the legacies of the Soviet era, steel accounted for 42 percent of Ukraine’s foreign currency earnings. No sector was worse hit by the crash in global investment spending than steel. Prices plunged and industrial output by January 2009 was falling at an annualized rate of 34 percent.59 As Ukraine’s economy slid into recession, ...

In October 2008 Ukraine had no option but to follow Hungary to the IMF. Kiev signed up to a $16.4 billion loan package. The IMF’s approach was not demanding by its usual standards. It asked for Ukraine to fully fund its budget, to set a realistic exchange rate and to ensure that its financial system was stable. But even this was more than Kiev could manage. The exchange rate was allowed to devalue from the overvalued rate of 5 hryvnia to the dollar to 7.7, though unofficially it traded as low as 10 to the dollar. The tax increases and subsidy cuts necessary to balance the budget were ruinously unpopular.60 Asked in 2009, “Who bears the most responsibility for the difficult socioeconomic situation in Ukraine?” 69 percent blamed the heroes of 2004, with 47 percent singling out Yushchenko and 22 percent naming Tymoshenko. Yushchenko’s personal approval rating hovered between 2.5 and 5 percent.61 The upshot was paradoxical. On the one hand, the impasse in Ukraine’s post–cold war development was more evident than ever. What hope there was of economic development lay in further integration with the West even at the expense of painful structural adjustment. On the other hand, by the au...

the Kremlin, the West scrambled to “reset” relations with Russia. But the fragility of the situation was painfully exposed in January 2009 when a dispute between Russia and Ukraine over unpaid bills and gas prices left Ukraine without heat in the depth of winter and interrupted flow through the pipelines running west to Europe.62 The dispute was resolved only with EU mediation and a price increase for Gazprom that would become an albatross around the neck of Prime Minister Tymoshenko. Though Ukraine was far from being headline news, it was already in 2008–2009 drifting into an explosive state. As Austrian finance minister Josef Proell presciently remarked in February 2009: “Ukraine is a very important keystone country and we must avoid a domino effect i...

If the immediate impact of the financial crisis was to impose an uneasy truce on the old battlefields of the European cold war, the shocking realization of 2008 was how far both sides were willing to go. In Moscow, NATO’s heedless attempt at expansion and the clash with Georgia would not be forgotten. Russia had made good on Putin’s announcement at Munich that the unipolar moment was passing. And the Americans knew it was true. But when they thought of multipolarity, they did not think first and foremost of Putin’s ramshackle regime. They thought of China. And so, in fact, did Russia’s own best analysts.1 The possibility of a Sino-American crisis was obvious to both sides. And the unexpected storm in the North Atlantic financial system further heightened tension.2 But Beijing and Washington avoided disaster. Neither side wanted to take the kinds of risks that produced the violent clash in the Caucasus.

In 2008 Chinese opinion was alarmed to discover that their prized portfolio of dollar assets contained not just actual Treasurys but GSE debt, issued to finance the expansion of American mortgage lending. As in Russia, public opinion in China was indignant. Why was poor China financing America’s excess? As a sign of its impatience, Beijing allowed its spokesmen to make dramatic and unusually frank statements. If the United States allowed the GSE to fail it would be a “catastrophe,” China let it be known.

Toward the end of 2008 the Atlantic magazine garnered an interview with a fast-talking manager of China’s sovereign wealth fund.4 The result was a startling insight into a topsy-turvy world. Over recent months, Gao Xiqing remarked, the world had watched as America, “after months and months of struggling with your own ideology, with your own pride, your self-righteousness,” had finally applied “one of the great gifts of Americans, which is that you’re pragmatic.” The Fed and the Treasury had intervened on a massive scale to stabilize the financial economy, so now, Ga...

Panic and crisis, turned US Treasurys into the most desirable asset in the world. Everyone wanted safety. Treasury prices were rising, yields easing, so too was the dollar. If China had wanted to diversify out of its dollar assets, this was the moment to do it. There was insatiable global demand for safe dollar assets. But what the crisis revealed was that China’s options were limited. What other safe assets were there to buy? For China to have bought Japanese bonds would have created an entanglement that was potentially even more explosive. European bond markets weren’t deep enough. China and America were locked together willy-nilly. Their interdependence was structurally conditioned and this went not only for foreign investments, but for trade too.

Given the scale of Chinese export success and its accumulation of foreign assets, Western observers are apt to believe that China’s growth must be “export dependent.” But this is an optical illusion that reflects our recalcitrant Western-centric view. Exports are important to China, and its insertion into the world economy has transformed global trade. But even before the crisis China’s domestic economy was large and it was growing extraordinarily rapidly, far more rapidly than China’s markets abroad.

China had made itself into an export champion, but in so doing it had also fostered imports—of commodities and components from Australasia, the Middle East, Africa, the rest of Asia and Latin America, as well as technology and advanced machinery from the West. A large part of the value in China’s world-beating exports was accounted for by imported raw materials and subcomponents. As a result, net exports accounted for a smaller share of Chinese GDP growth before 2008 than one might imagine. In fact, no more than one third of China’s growth from 1990 was driven by exports, with two thirds coming from domestic demand.7 This was a very different balance from that of a truly export-dependent economy, of which Germany was the quintessential example. With slow domestic investment and consumption, the vast majority of Germany’s growth after 2000 was accounted for by foreign demand. In China, far and away the main driver of growth was its enormous wave of domestic investment. As China’s cities expanded and its infrastructure modernized at a staggering rate, the physical reconstruction of the country sucked the entire Chinese economy up with it.

By 2008 the immense dynamism of China’s domestic demand and its central position as a regional trading hub in East Asia suggested to some analysts that Asia might be on the point of “decoupling” from America and Europe.8 In the spring of 2008, as the rest of the world slid toward recession, Beijing’s main worry was that China’s economy was expanding too fast. Growth in consumption was roaring along at more than 20 percent per annum. The People’s Bank of China raised interest rates and government fiscal policy was tightened to choke off the boom. Meanwhile, China’s government machine was reorganized to concentrate responsibility for more balanced national growth in centralized superministries.9 What no one reckoned with was the sheer force of the global trade collapse. Whereas in July 2008 Chinese exports were growing by 25 percent, imports by 30 percent and FDI by 65 percent per annum, six months later China’s exports were falling by 18 percent, imports by more ...

shutter their Chinese operations.10 At the same time, cash-hungry Western banks such as Bank of America, UBS and RBS sold up and pulled out. But these were pinpricks when compared with the impact of falling export orders on China’s labor market. As the winter of 2008–2009 approached, 30 percent of China’s gigantic annual surge of college graduates—5.6 million per annum—were unable to find work. The reserve army of tens of millions of rural migrants fared even worse. For the Mid-Autumn Festival in October 2008, 70 million returned to their homes in the provinces, of whom only 56 million made the trip back to the cities after the break. Of those, according to World Bank estimates, 11 million were without jobs. Altogether, at least 20 million, and perhaps as many as 36 million, Chinese workers were left idle.11 Ever watchful for signs of domestic social unrest, Beijing knew that it had to react. Already on November 5 the State Council convened an emergency meeting to agree on a 4 trillion yuan ($586 billion) spending program. This amounted to a remarkable 12.5 percent of 2008 GDP. It was supplemental to existing investment plans and was to be disbursed by the end of 2010. It was th...

called on local government to “make every second count.” Central Document No. 18 shocked the local party apparatus into action. In the words of a leading American analyst, Document No. 18 “added to the sense of urgency, communicating the sense tha...

The nations represented at the G20 might represent only 10 percent of UN member states and 60 percent of the world’s population, but they were responsible for 80 percent of trade and 85 percent of global GDP and their share was increasing. There was no pretense of equality within the G20, let alone with states beyond. But the members of the G20 did at least recognize one another as elements of the global economic system that were too significant to ignore.

But when in 2009 the UN General Assembly convened its own committee on the global economic crisis, the G20 ignored it.

Why the G20 would matter, it seemed, was that it would be the channel through which the “great powers” set the agenda for change in other global institutions. In November 2008 there was an agreement between the FSF—the global assembly of bank regulators—and the IMF for the FSF to define new standards for financial regulators, for the IMF to oversee their implementation and for all financial organizations to widen their membership to include the assertive new emerging economies.